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Business News/ Money / Calculators/  Why banks resort to misselling
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Why banks resort to misselling

Commissions from sale of third-party products are important for banks' profitability. Hence, the strong sales push

Photo: Hemant Mishra/MintPremium
Photo: Hemant Mishra/Mint

Banks are struggling to make profits as their non-performing assets (NPAs) are rising and net interest margins (NIM) are falling.

According to data from the Reserve Bank of India (RBI), gross NPAs (overdue loan accounts), went up from 56,400 crore in 2008 to 2,39,500 crore in 2014. NIMs (difference between interest earned and interest paid by banks) have fallen from 3% in 2005 to 2.7% in 2014, with nationalised banks having the lowest average of 2.2%. This puts pressure on profits coming from a bank’s basic business.

A bank borrows from depositors and lends to businesses and individuals. The difference in the interest rates minus costs and taxes is the profit it gets from its basic banking activity. But pressure on profits from the core business has forced banks to cultivate income from non-core banking activities, including selling third-party products such as insurance policies and mutual funds, for a commission.

“The phenomenon of commission being a significant part of operating profits is a function of the branch intensive banking model in India… operational costs are high putting pressure on the margins," said Naresh Makhijani, partner and head, financial services, KPMG in India. This is evident from the fact that commission as a percentage of other income (non-core business) has risen for banks in the past 10 years. Even though this percentage is down from the peaks seen in 2012, it remains high.

RBI data shows that for all scheduled commercial banks commission as percentage of other income has risen from 42% in 2005 to 53% in 2014. Mint takes a look at what this increasing focus on non-core activity means and how it impacts you.

Sources of income

A bank’s income is made up of two streams of income—interest income and other income. Other income includes fees and commissions received by the bank. These are earned from sales of third-party products such as mutual funds, insurance policies, gold coins, treasury income and fees from charges levied on customers for all products including banking products.

Together, income from these two buckets makes the topline of a bank, but for any bank, 85-90% of its topline comes from basic banking. The actual income earned by a bank—which is the difference between the interest earned by them from borrowers and the interest paid out by them—is measured by net interest income (NII). NII to total assets is often known as NIM, which reflects the operational performance of banks. NIM is an important metric to track as it can help in measuring thinning margins for banks from core banking activities.

RBI data shows that NIM has been declining over the years for scheduled commercial banks in India. “NIM, on an average, is said to be healthy if it is in the range of 2.9-3%," said Nikhil Rungta, lead analyst-banking and financials, Anand Rathi Institutional Research, Anand Rathi Financial Services Ltd.

This declining NIM trend is particularly pronounced for public sector banks. Their NIM has fallen from 3.18% a decade ago to 2.45% in 2014. “With margins thinning as most (banks) are vying for market share, and with certain public sector banks earning NIMs below 2%, this section of income is under threat," said Sanjiv Bhasin, executive vice-president, markets and corporate affairs, India Infoline Ltd.

According to Makhijani, this pressure is due to tepid loan growth, polarisation in rate environment impacting lending yields and increase in bad loans. The trend is expected to continue. “Interest income will be under pressure as we see new payments banks and small finance banks come up. More licences pose a threat to private and public banks," said Bhasin.

Rising book of bad loans only means a higher share of NPAs, which again affects the interest margins. Bank NPAs stood at over 7 lakh crore as of November 2015, according to industry estimates. “Banks’ NIMs are coming down from last few quarters due to higher NPA formation. Every time a bank declares a loan as NPA, it not only reverses unpaid interest but also stops recognition of future interest income. This has forced banks to look into generating fee and commission incomes, which are not directly linked to the loan portfolio," said Hitesh Agrawal, head-research, Reliance Securities, the broking arm of Reliance Capital Ltd.

What constitutes profits?

Given the falling NIM and concerns over rising NPAs, it may come as a surprise that profits of banks are rising. According to RBI data, profits for all scheduled commercial banks have been rising at 15% compounded annual growth rate (CAGR) for the past 10 years. Private banks have outperformed overall sector’s growth by increasing their profits at 25% CAGR. “In order to maintain the profitability levels, banks have been looking at other sources of income. This has resulted in various third-party tie-ups with fund houses, insurance companies and introduction of other banking products such as EDC (electronic data capture) machines, products focused on non-resident Indians and affluent segments, gold coins, and more," said Makhijani.

Now, if we look at the share of other income to total income, we see that this ratio was highest for foreign banks (23%), followed by private banks (16%) and then the public sector banks (9%). Other income forms a sizeable part for private and foreign banks.

Within other income, almost half of the pie comprises commissions. This is more pronounced for private banks—on an average, 64% of their other income came from commissions in 2014 versus 56% in 2005.

What further points to the importance of commission income is its ratio to operating profits. “Commission income contributed 22% of operating income for private banks and 12% for public sector banks," said Agrawal.

Commission to net profit ratio also indicates how important commissions are to banks. The higher the ratio, the more crucial is the commission income for banks. “Commission income was and will be a significant contributor to the profits of any bank. The recent change in cap of interest payable on savings account would be the trigger for higher commission income as banks have to source the higher interest outgo," said Bhasin.

The average commission to net profit has been over 65% for banks. “In the current scenario, where growth in terms of business is happening at a slower pace, commission has become an important source for the banks to drive profitability," said D.K. Aggarwal, managing director, SMC Wealth Management Services.

When commission contributes a large portion to net profit, banks would want to concentrate on the more lucrative part of business. Note that the interest income to net profit ratio would also be high as interest income is large for banks. But profits from interest income as measured by NIMs are declining while a substantial chunk of commission income goes to profits of the bank. “In fund based revenue, the bank first accepts deposits and then lends to earn revenue. Scope to earn higher profit margins is limited due to competition in lending segment. In a fee-based revenue model, little capital needs to be deployed and, hence, return on capital employed improves with increase in such revenues," said Makhijani.

Within the bucket of commissions, “majority of third-party income comes from sale of insurance," said Rungta.

Banks do not disclose commissions from sale of third-party products but industry experts estimate this to be a good 20-30% of the total commissions. Mint wrote to the banks for their comments on this but did not receive any response. However, analysts say that banks have started depending on other income for their bottom line and that commissions form a large chunk of other income. “Commission or fee income is a significant part of the operating income of banks," said Agrawal.

Looking at these indicators, there is enough reason to believe that banks have an advantage in pushing third-party products; something we know anecdotally.

What this means for you

When you walk into your bank branch or talk to your relationship manager, you would often be advised to buy insurance or mutual funds. This advice may not be backed by a need analysis but by the commission the bank will earn if you buy the product. “Bank employees often arm twist clients into investing in mutual funds or insurance to earn commissions," said Bhasin.

There is widespread belief that some bank branches are mis-selling insurance and churning mutual fund portfolios to get more commissions. Commissions from mutual funds range between 0.5% and 10% (highest commissions are for products with lock-in period). Even though there is a cap of 1% on upfront commissions, banks are able to negotiate with fund houses to get more. “Banks bargain hard on mutual funds and insurance commissions at the start of a financial year by stating that they would sell a certain amount during the year. They receive the commissions upfront and have to work to meet that sales target," said a senior bank official at a leading private bank.

Commissions for insurance sales could be as high as 40% in the first year, depending on the insurer and the insurance policy. “Mostly, bankers compel the public to take a policy even when the request is to open a savings bank account. Life insurance policies are almost made compulsory for those taking any loan—gold, personal, housing or educational loans. In case of other commercial loans, general insurance is being pushed," said K. Kathirmathiyon, secretary, Coimbatore Consumer Cause, a non-government organisation working to create awareness about consumer rights.

This is despite RBI guidelines that state: “as the participation by a bank’s customer in insurance products is purely on a voluntary basis, it should be stated in all publicity material distributed by the bank in a prominent way. There should be no ‘linkage’ either direct or indirect between the provision of banking services offered by the bank to its customers and use of the insurance products."

However, commissions, especially from insurance products, continue to form a significant chunk of banks’ profits.

Mis-selling of financial products is difficult to catch because products are sold through a verbal sales pitch. In the case of banks, the sales are to existing bank customers who, because of the relationship with the bank, believe the sales pitch of their trusted bank official. Once the verbal spiel is over, the customer simply signs the documents pushed across the table by her own relationship manager.

The central bank has a Charter of Consumer Rights in place. An RBI spokesperson told Mint in an emailed reply: “The extant regulatory guidelines on mis-selling of products by banks primarily provides thrust on the aspects of transparency and disclosures. Banks have been advised to restrain from divulging the information secured from the customers while opening the accounts for the purpose of cross-selling of products. The Charter of Customer Rights recently formulated by RBI has an exclusive right on suitability which addresses the issue of appropriateness and suitability of products/services offered to customers."

Guidelines issued by RBI in June 2013 said, “Banks should disclose to the customers, details of all the commissions/other fees (in any form) received, if any, from the various mutual fund/insurance/other financial companies for marketing their products." Banks, however, do not follow these guidelines.

You, as a customer, need to be careful when dealing with your bank. You should understand a product before buying it—ask as many questions as you want to fully grasp all the details. And do not take a hasty decision. Simple way to avoid being sold products you don’t need is to make your investments goal-based. Start with analysing your needs and buy products that will efficiently help you reach these goals.

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Published: 21 Dec 2015, 12:39 AM IST
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